My most recent books are the Leader's Guide to Radical Management (2010), The Leader's Guide to Storytelling (2nd ed, 2011) and The Secret Language of Leadership (2007). I consult with organizations around the world on leadership, innovation, management and business narrative. At the World Bank, I held many management positions, including director of knowledge management (1996-2000). I am currently a director of the Scrum Alliance, an Amazon Affiliate and a fellow of the Lean Software Society. You can follow me on Twitter at @stevedenning. My website is at www.stevedenning.com.

Why IBM Is In Decline

It’s been a striking week for IBM. In its June 2014 issue, Harvard Business Review (HBR) published an interview with IBM’s former CEO Sam Palmisano, in which describes how he triumphantly “managed” investors and induced IBMIBM’s share price to soar.

But IBM also made it to the front cover of Businessweek (BW) with a devastating article. According to BW, Palmisano handed over to his unfortunate successor CEO, Ginni Rometty, a firm with a toxic mix of unsustainable policies.

The key to Palmisano’s success in “managing” investors at IBM was—and is–“RoadMap 2015”, which promises a doubling of the earnings per share by 2015. The Roadmap is what induced Warren Buffett to invest more than $10 billion in IBM in 2011, along with many other investors, who were impressed with the methodical way in which IBM was able to make money. (Buffett’s investment was striking because of his long-standing and publicly announced aversion to investing in technology, which he confessed he didn’t understand.)

After all, IBM under Palmisano had doubled earnings per share in Roadmap 2010, and now it is “on track” to do the same by 2015 under the leadership of Ginni Rometty, another long-time IBMer, who took over as CEO in 2012. She has embraced the Roadmap with as much gusto as her predecessor.

Yet for critics of IBM like BW, “Roadmap 2015” is precisely what is killing IBM. According to BW, IBM’s soaring earnings per share and its share price are built on a foundation of declining revenues, capability-crippling offshoring, fading technical competence, sagging staff morale, debt-financed share buybacks, non-standard accounting practices, tax-reduction gadgets, a debt-equity ratio of around 174 percent, a broken business model and a flawed forward strategy.

According to BW, IBM’s RoadMap 2015, if adhered to, virtually guarantees that its woes will worsen. “It would be hard enough for Rometty to bring IBM into the cloud era,” analyst Bill Fleckenstein is quoted by BW. “Doing so while yoked to her predecessor’s $20-per-share earnings promise is almost impossible.” Even if IBM does somehow manage to make its earnings-per share targets, what will be left of this once-great firm?

The ticking money-bomb

Critics point to Palmisano’s exit package from IBM, enabling him to clear a total of $225 million, including all the options, restricted stock, pensions, deferred compensation, bells and whistles.

IBM’s supporters see Palmisano’s compensation as thoroughly justified by a job well done. “If Palmisano were sitting on a money-bomb like this after having driven IBM’s share price into the ground, we would expect some outrage,” writes footnoted*. As it is, IBM’s market capitalization rose by $85 billion while Palmisano was chief executive, and that’s no small thing for shareholders. The company’s share price has risen 91 percent since mid-March 2002 (with most of the gains since 2008), far outstripping the S&P 500.”

But BW is suggesting, as in 2008, IBM is exactly that: a ticking money-bomb. It’s just that the fuse is on a delayed switch. Palmisano got out while the going was good, leaving the unfortunate Rometty to deal with the impending wreckage.

What is IBM really about?

Palmisano is, according to HBR in 2006, “a true-blue IBMer, who started at the company in 1973 as a salesman in Baltimore,” with “a visceral attachment to the firm.” He is “a results-driven, make-it-rain, close-the-deal sort of guy.” He also famously held a ValuesJam, in which thousands of IBM’s employees joined in an open debate about the very nature of the computer giant and what it stood for. At the conclusion, Palmisano declared IBM’s commitment to three values: “Dedication to every client’s success,” “Innovation that matters,” and “Trust and personal responsibility in all relationships.”

However critics—and many staff—suggest that what drove actual decision-making at IBM under Palmisano was not so much “clients”, “innovation” or “trust’, but a relentless drive to grow earnings per share, no matter what the cost.

Palmisano’s 2014 interview offers some corroboration of this diagnosis. In the long interview, Palmisano never once mentions the word “client” or “trust”. He mentions “innovation” only once, and then to point out how little money it involves in the overall scheme of things. “Your innovation and long-term investments are a very small portion of the SG&A [selling, general, and administrative expenses] pot—maybe 4 percent.” Somehow IBM’s values got lost in the shuffle.

Embracing “the dumbest idea in the world”

In the HBR interview, Palmisano reveals himself to be a true believer in maximizing shareholder value—the very idea that even Jack Welch has called “the dumbest idea in the world.”

“We gave investors annual outlooks, and we gave them earnings,” Says Palmisano. “You have to give them something—they’re owners… You want people to have some clarity so that they will invest in you.,, In 2006 we told [Wall] Street that we would go from $6 to $10 in earnings per share by 2010. We then tied long-term compensation to that model… We executed it, and it worked for us.”

For Palmisano, managing IBM was all about generating investment returns for the big shareholders. “If you’re a small, young company and you’re driving revenue without a lot of earnings, you’ve got a completely different model… The Berkshire Hathaways, the Neuberger Bermans, the Capital Worlds are looking at a longer-term cycle for their investment returns.”

Palmisano treated the large shareholders as real owners. “We decided to treat our large shareholders with total transparency, as best we could within regulations. We would meet with them. We’d have a couple of them come in every quarter and talk with the entire senior management team… Fidelity, Capital, BlackRock, T. Rowe, Wellington, Neuberger Berman—the big guys. They would each bring four or five portfolio managers…. They could spend as much time as they wanted with the businesses. The meetings went on for hours.”

Palmisano found that the big shareholders supported his primary focus on earnings per share, ahead of growing the business. “Basically, the shareholders were just asking us to be friendly with capital allocation. They wanted more margin expansion and cash generation than top-line growth, because they knew that if we generated cash, we’d give it back to them in the form of a share buyback or a dividend, not a crazy large acquisition that no one else could see value in.” And so Palmisano became very friendly.

An unholy alliance: top managers and big investors

Palmisano argues that such investors are good for business, and he may be right, if you define business as making money for the top managers and the big shareholders. Palmisano’s lyrical memories of the sessions that he had with the big investors in those meetings that went on for hours did indeed end wonderfully for him. How could it be otherwise?

Just think about the scene. You have the IBM C-Suite which is hugely compensated for jacking up the share price. And you have the managers of the big investors who are also hugely compensated if they get reliable information as to exactly how the share-price is going to be jacked up. Should it be any surprise that this self-interested cabal ends up jacking up the share price? The question remains: was this good for IBM—and society—or not?

Growing the real business

Palmisano feels that IBM not only grew shareholder returns but also the real business. “We invested $6 billion a year in R&D. Throw in another few billion for acquisitions of technologies that we weren’t organically developing, and I’d say $10 billion, $11 billion a year. It was 10 percent of revenue. There aren’t a lot of companies investing 10 percent of revenue. At IBM, we knew we had to invest for the long term. Not everything works out. That’s why it’s called research and development.”

Palmisano doesn’t believe that the metrics, which Clayton Christensen criticizes, are a problem. “I think it’s the maturity of management…. you can’t be having a crappy year and just say, ‘I’m in it for the long haul.’ Nobody’s going to buy that, right?” In effect, you have to deliver results in both the short-term and the long-term.

Palmisano views his role at IBM as a steward of a machine that makes money for the big investors. “You’re a proprietor at a point in time; you’re a steward. You’re not the founder. You’re there to protect the entity for long-term returns.”

Palmisano believes in share buybacks for “mature” companies. “You have jillions of dollars of cash on the balance sheet. Instead of buying an asset for $8 billion, why don’t you give some of that back?” … you’re not a start-up anymore. You begin with what I call act one—the first phase, the hit product, a great run. You’ve got companies in great runs right now, the Googles and the Facebooks. Good ideas, great returns, but then all of a sudden, you need an act two. Well, jeez, is act two going to propel you from $30 billion to $100 billion? That’s a little tougher… the investor says, “Wait a minute. I expect you to be more mature now. Your company’s not young anymore.” The investor expects returns—consistent returns.”

So Palmisano, and Rometty after him, set out to deliver consistent returns. The cost to IBM of doing so has been considerable.

The cost of consistent shareholder returns

Under Palmisano’s leadership, the steps taken to ensure IBM’s steadily increasing earnings have created significant issues, as you might expect from pursuing “the dumbest idea in the world.”

Relentless cost-cutting: Employees bitterly refer to the Palmisano’s Roadmap 2015 “Roadkill 2015.” The cost-cutting began with “Roadmap 2010” has continued, long after obvious fat has been removed. Workers complain that the cuts now affect IBM’s muscle bone and vital organs.

The shift to cheaper expertise: IBM shifted technical expertise from high-paid US staff to low-salaried staff in India, while cutting back on staff in the US. Its Indian operations grew from 3,000 to well over 100,000 employees.

Automatic culling of staff: Managers are required to cull a certain percentage of their staff, regardless of absolute performance.

Fading technical expertise: IBM’s failure to win the bid for the CIA’s cloud computing contract, worth some $600 million, is highlighted by BW. This bid should have been IBM’s “home field,” given its long experience with mainframes and government contracting. Its bid was 30 percent lower than Amazon’s, which had no experience with government, yet IBM’s bid was rejected on technical grounds. An appeal by IBM was even more humiliating: it only highlighted how technically inferior its proposal was and so the bid was withdrawn.

Bureaucracy and lack of agility: Despite talk of delayering and collaboration across silos, IBM still has a steep hierarchy, with thirteen layers of management. When combined with the relentless cost-cutting and offshoring and the fear that these practices generate, the agility of the organization tends to be compromised.

Acquisitions instead of innovation: Despite spending some $6 billion on R&D, IBM has been falling behind its competitors technically. This was one of the factors behind its losing bid for the CIA project. IBM’s response has been to buy firms with needed expertise, such as Aspera, which helps clients move large volumes of data quickly; Cloudant, a service for mobile and Web apps; TeaLeaf, a tool for retail marketers, and SoftLayer Technologies, a cloud computing firm. What remains to be seen is how well those acquired firms will do when faced with the demands of Roadmap 2015 and the IBM bureaucracy.

Reliance on financial incentives: “People need to understand,” says Palmisano, “that if they execute the model, they will be rewarded.” The problem is that when incentives are purely financial, motivation suffers. And when the financial incentives are as skewed towards the top as they are at IBM, the costs in terms of motivation are considerable.

Sagging staff morale: When layoffs are a central part of the business model, especially needless layoffs for financial positioning, it creates disaffected employees. Even IBM’s fans concede that staff morale is low. Despite many talented and committed staff, the relentless cost-cutting, the steep hierarchy and lack of agility have taken their toll, particularly in key areas like innovation and generating customer delight.

An imploding business model: “IBM has three core businesses: services, software, and hardware. When times are good, they work in concert,” says BW. “A decline in one of these businesses can hobble the whole company, a destructive spiral IBM is fighting to break. As more customers get their computing done cheaply in the cloud, IBM is selling less hardware, which imperils its high-margin software products. And any perception that IBM is adrift threatens its ability to advise clients on anything at all.”

A cloudy future strategy: “The cold-sweat scenario for IBM,” says BW, “is that it does catch up to Amazon and other cloud providers—only to find that competition has driven margins toward zero. In March a price war broke out among Amazon, Google (GOOG), and Microsoft, as each announced cuts of as much as 35 percent on computing; 65 percent on storage; and 85 percent on other services. Rometty has made two promises to investors: to lead corporate IT into the cloud and to deliver lustrously thick margins. Those goals may be irreconcilable, as long as IBM faces competitors willing to make the cloud a place of ever-diminishing returns.”

The challenge for Rometty

When Rometty took over as CEO, she had a decide what to do about the tension between the Roadmap 2015 and the internal problems that it had caused. She opted to live with the tension and continues implementing Roadmap 2015.

She also endorsed Palmisano’s three values, reinforcing them with a single purpose—“Be essential”—and nine practices: “Put the client first,” “Listen for need and envision the future,” “Share expertise,” “Restlessly reinvent,” “Dare to create original ideas,” “Treasure wild ducks,” Think, prepare, rehearse,” “Unite to get it done now,” and “Show personal interest.” Communicating this 1-3-9 throughout IBM became a high priority.

“Last year,” BW reports, “she began distributing black plastic cards bearing the phrase “One Purpose: Be essential” to IBM’s roughly 50,000 managers and has been known to demand to see them as she walks the halls.” When I asked IBM staff whether this story was really true, they told me that it was implausible since the cost of printing 50,000 cards was exactly the kind of cost that would be automatically be cut in today’s IBM.

And therein lies the rub for Rometty. If her 1-3-9 package of purpose, values and practices were the whole IBM story, or even the main story, she might be on a winning trajectory. But when they are seen against the overriding pressures of Roadmap 2015, no one hears the messages. Any “wild ducks” that are still left on the staff keep their heads down and take care not to make waves.

The problem was, and still is, how to reconcile Roadmap 2015 with the steps needed to deliver it: capability-crippling outsourcing, unsustainable work pressures, fading technical competence, lagging innovation and sagging staff morale. The two tracks are incompatible—something that’s been obvious to IBM staff for a very long time.

In order to keep up the growing earnings per share despite the internal problems, Rometty has resorted to ever more ingenious financial engineering, including non-standard accounting practices (125 in IBM’s annual 2013 report), borrowing to fund share buybacks, and Tax reduction gadgets.

Whatever’s wrong with IBM isn’t recent. Rometty is following exactly the Palmisano plan. We are just further down the track, and its unsustainability is becoming steadily more apparent. As time goes on, the tea-leaves become easier to read.

What’s striking is Palmisano’s blithe innocence as to any significant issues with what he has wrought at IBM. Palmisano is glad, BW reports “to see [his approach] continuing under Ginni.” Indeed, in April 2014, he launched the Center for Global Enterprise to distribute this thinking to other companies.

The right level of discussion

This is not just a technical wrangle about whether Roadmap 2015 is the right metric to apply. It’s a discussion about what we value as a society. Is the organization going to be an instrument of society or simply a short-term money-making machine for a cabal of its top managers and a bunch of major shareholders?

Is IBM, as Peter Drucker would suggest, a social institution, which can harness the capacity and potential of its people because it respects them? Or is it a money-making machine that throws talented people away like so many broken machines?

Palmisano makes no apology for being steward of a money-making machine that takes no prisoners. In fact, he celebrates it. And indeed sees no alternative. It’s simply the way things are. The possibility that he got rich—legacy-wealth rich—in the process may have anything to do with it never crosses his lips. As Upton Sinclair noted, “It’s hard to get a man to understand something when he is being paid not to understand it.” Particularly when the amount of the payment is $225 million.

The challenge for IBM: a different kind of management

The real challenge for the CEO of IBM is a fundamental shift in business goals and culture. Instead of a world where a high-pressure sales teams can lock in customers to long-term contracts for using unchanging software with high margins, now IT services providers have to compete with firms that offer continuous innovation, pay-as-you-go fee structures and freedom to exit any time. To compete successfully in this emerging world, the IT service providers will have to delight their customers on a continuing basis, by offering continuous innovation.

As John Wookey, who runs advanced products for Salesforce, told the New York Times: “The economics are different, but what is really different is the relationship with the consumer. We issue a new version of the product every four months. If the customer doesn’t like it, he stops paying.”

“The best business returns,” says Warren Buffett, “are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.” Put another way, “IBM had that stickiness and indispensability to many large corporate and government institutions worldwide.” The question is whether this way of doing business is coming to the end of its effective life. Today clients prefer flexibility to stickiness.

Established firms like IBM are used to operating in a world where new versions of packaged software come out every few years, making it difficult to get out of a license when company data depends on it. The emerging world of cloud computing will require much greater agility. “The hardest thing is to be successful again when you’ve been successful in the old world,” said Wookey.

A new kind of management is required, focusing on customer delight as the new bottom line of the firm’s business. The old giants will have to learn how to disrupt their own cash cows and rapidly develop new products that have not even been heard of. Innovation has to happen not in sporadic “values jams”, but on a continuous basis.

Traditional management won’t get the job done. Firms will have to set aside traditional mantras like ‘maximizing shareholder value‘. They will have to learn how to be part of the emerging creative economy. The firms that Palmisano makes fun of, “with names like a piece of fruit” (i.e. Apple [AAPL], have shown us that any firm—even a very large firm—can master it. It’s not rocket science. More than a score of books have been written about it.

IBM has made other transitions in its long life—last time with an outside CEO.

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.

Comments

Blah blah blah blah blah …. so basically your ForBSes talking Head diatribe boils down to your hate for the big “payoff” that Sam Palmisano (you must one of those CEO haters), that IBM BUYS technology rather than innovates it (you mean like CrApple does?? Latest is buying BEATS a freakin speaker “name” for more crap made in China! Name a single NEW ground breaking Technology from CrApple the great iNOvator, buyer or thief of Technology!??) and some “bad employee morale? (where the proof on that?).

IBM has been out front of everyone else, including CrApple, DIVESTING themselves at fat profits, of dying technologies by getting rid of all PC hardware holdings, small server hardware holdings and other hardware tech that is seeing vastly diminishing returns, while their counterparts such as Dell, HP even CrApple see’s computer sales floundering. IBM INVENTED the Cloud and is more into this technology than anyone short of Google – CrApple has NOTHING in Cloud Tech. I’ve had IBM stock since the 70′s, seen it split 5 times and it has been rock solid with Dividends that can be counted on. How long has Greedy CrApple been paying Dividends to IT STOCK HOLDERS???

We’ll see who’s right about IBM in the next 10 – 20 years, but as history shows, when the talking-heads like you at ForBSes are wrong and it’s often (like forcasting CrApple would hit $1200 p/share a couple years ago) you all HIDE under your couch based offices and never admit being wrong.

I guess the point that you are missing is: the manager that run IBM today can not be compared to those that run the company in the 1970ies.

I am working for IBM now almost 15 years; and I know many folks who have been around for 25 or 30 years. And basically everybody is an agreement, that our company is changing dramatically – and not to the better.

There is a reason, why many people talk about “Roadkill 2015″. This “earnings per share” number does nothing for your dividend, but it dramatically decreases our ability to create own, organic growth. Todays IBM is able to buy the right assets; we have a very hard time to come up with great products ourselves. And why is that … in my opinion because the workforce is slashed and slashed all over the place. And those people that remain have to _fight_ budget constraints and all kinds of crazy every other day in order to _do_ the job they are paid for.

Besides that, I have seen the practices that IBM uses nowadays when firing people (in the US; and India, China, …). Basically, the message is: “this company does not care about its employees.” So it should not be a surprise that most IBMers I have decided to “yes, do their work” … but the times when people were proud to work for IBM (and would tell there friends or kids to get a job there) are long over.

If you really think that these are great signs for the future of your stocks; well, that is your opinion. But you should realize that it is just an opinion, and that your “curse words style” language is definitely helping to make your point.

You had a dream man, IBM did not invent at all the cloud unless you think that cloud are the services ibm was providing to customers 30 years ago and let’s take a date in 10 years from now….. if IBM is still alive it will be with completely different business,….. and business model as we can guess the profile. Buying companies delivering short term profit and selling low profit contributors….. IBM doesn’t care about customers, even less about employees, IBM senior leaders (those meeting with majors investors) do only think about investors and themselves……

Most likely you are not really interested in discussing that, but just for the records; other folks might find this “helpful”.

Just coming back from an IBM internal event with a bunch of “ordinary” employees. Let me tell you about the views of those folks: a) they claim that 80 to 90 % of IBMs workforce does NOT participate from the profits that this workforce produces b) they think at at least for 10 years, far too much “profit” (up to 70% each year) ended up with the shareholders c) someone pointed out that IBM as new “caste” – as IBM TRIPPLED the number of executives since 1998 to over 6500. Many of them regarded as over-paid, damage-creating, unable-to-listen psychopaths

In one sentence: they all agreed that IBM is BEYOND cultural bankruptcy. Now the bad news for you: when a company goes “cultural bankruptcy”; you can start the countdown for the financial meltdown.

So, if it turns out that there will be an agenda 2020; and if it would just say to keep these insane EPS numbers … there wont be an IBM in 2025.

In both this and the previous article you’ve done a great job of stepping back while looking deep into the dynamics. What’s evident to me is that, in the case of IBM, they have values but aren’t using them to make decisions. This automatically places the company in the back seat because decisions are focused on what used to work but not what’s needed now. Persisting with the Roadmap despite evidence that’s it’s debilitating the health of the company means all is not well no matter how good the past adds up monetarily. Yes, IBM’s past capacity to balance short term with long term has been advantageous. But unless IBM becomes more aware of what they’re using to focus their decision making, as you’ve made abundantly clear, then it’s destined to lose its edge. Complacency and perseverance are sometimes entangled so that there is failure to see when to step back and revisit how to become essential to more than just shareholders.

Thanks for these pertinent comments. What is staggering to me is the contrast between dedication and commitment and customer focus that I see in people in IBM at the working level, and the total disconnect with what’s going on at the top.

Rometty’s “one purpose, three values and nine practices” are actually quite good. But wandering around the corridors and asking people whether they have the card is totally counterproductive. It’s the top that needs to ask themselves why they aren’t implementing their own principles.